Is Chong Fai Jewellery Group Holdings (HKG:8537) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Chong Fai Jewellery Group Holdings Company Limited (HKG:8537) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Chong Fai Jewellery Group Holdings

What Is Chong Fai Jewellery Group Holdings's Net Debt?

As you can see below, Chong Fai Jewellery Group Holdings had HK$31.0m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. But it also has HK$33.0m in cash to offset that, meaning it has HK$2.06m net cash.

How Strong Is Chong Fai Jewellery Group Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chong Fai Jewellery Group Holdings had liabilities of HK$49.1m due within 12 months and no liabilities due beyond that. Offsetting these obligations, it had cash of HK$33.0m as well as receivables valued at HK$1.92m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$14.1m.

While this might seem like a lot, it is not so bad since Chong Fai Jewellery Group Holdings has a market capitalization of HK$49.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Chong Fai Jewellery Group Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely. When analysing debt levels, the balance sheet is the obvious place to start. But it is Chong Fai Jewellery Group Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Chong Fai Jewellery Group Holdings reported revenue of HK$116m, which is a gain of 23%, although it did not report any earnings before interest and tax. With any luck the company will be able to grow its way to profitability.

So How Risky Is Chong Fai Jewellery Group Holdings?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And we do note that Chong Fai Jewellery Group Holdings had an earnings before interest and tax (EBIT) loss, over the last year. Indeed, in that time it burnt through HK$5.1m of cash and made a loss of HK$1.4m. Given it only has net cash of HK$2.06m, the company may need to raise more capital if it doesn't reach break-even soon. Chong Fai Jewellery Group Holdings's revenue growth shone bright over the last year, so it may well be in a position to turn a profit in due course. By investing before those profits, shareholders take on more risk in the hope of bigger rewards. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Chong Fai Jewellery Group Holdings that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.